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“I have a working knowledge of the entire universe and everything it contains”

As Sheldon Cooper would have it, physics explains everything. All the workings of the universe, from black holes and dark energy to the financial markets down to the inner workings of our brains and the atoms and molecules that comprise them are assumed to be controlled by the same set of fundamental physical laws. That goes a long way towards explaining why the finance industry hires so many physics Ph.Ds. Anyway, or so the thinking goes, the only people who are studying anything really interesting are – like Sheldon – theoretical physicists.

The misplaced triumphalist arrogance of certain physicists (and many alleged experts) is nothing new, of course. For example, the discoverer of the positron proclaimed that, thenceforth, “the rest is chemistry.”

Unfortunately for Sheldon, the ability to reduce everything to physics does not mean that we can start with physics and reconstruct – or even model meaningfully – the universe. In fact, the more we learn about fundamental physics, the less relevance it seems to have to our everyday world, largely on account of scale and complexity. And, at each new level of complexity, new properties appear and new stuff happens. Scale change leads to fundamental change.

All of which, of course, leads to new sets of experts claiming to have uncovered “it.” Triumphalists exist at each level (human nature being what it is). For example, NYU political scientist Bruce Bueno de Mesquita is convinced (he avoids clear testing, not surprisingly, even though there is some reason to think he has had success) that he can predict the future via mathematical modeling. In the finance world, mainstream economists are convinced that they live in a pristine world where markets are efficient and models express reality.

As if.

In 2003, Nobel laureate Robert E. Lucas Jr. began his presidential address to the American Economic Association by proclaiming that macroeconomics “has succeeded: Its central problem of depression prevention has been solved.” Current Fed Chair Ben Bernanke helped to publicize the alleged “Great Moderation” in a 2004 speech. The financial crisis of 2008-09 demonstrated that those ideas were more than a little bit lacking, at least in their most aggressive forms. Reality has a way of doing that.

The universe (like the markets) offers ongoing surprise. The world (including the markets) is always stranger and more interesting than we have imagined. It may well be stranger than we can imagine.

Traditional financial theory – which, for example, postulates that the proliferation of new financial assets such as futures, swaps and other derivatives provides for greater diversification and risk sharing – often misses this crucial point, as the examples above amply demonstrate. Anyone with even a mite of common sense (or who looks at some actual data) should be able to ascertain that the existence of trillions of dollars’ worth of highly exotic financial instruments creates more instability, not less. CDOs, anyone? Some recent research by MIT’s Alp Simsek (discussed recently by Mark Buchanan here), considers how new derivative instruments influence market stability. His conclusion – based upon actual data rather than ideology – is not a happy one.

“In a world in which investors have different views, new securities won’t necessarily reduce risks,” Simsek said in an MIT interview. “People bet on their views. And betting [what Simsek labels “speculative variance”] is inherently a risk-increasing activity.” (For evidence of current systemic risk levels via NYU’s VLAB, see helpful posts from Barry Ritholtz here and here.)

For most of us, that shouldn’t be a surprise. People speculate in the markets. It’s what they (we) do. Moreover, a group of physicists (hmmm) has shown that the theoretical ideal of complete markets should actually be inherently unstable because, in approaching this limit, tiny shocks to the system demand huge portfolio changes. Such a market could only remain efficient via an ever faster and more vigorous churning of positions. For most people, and surely for anyone who has ever managed money, the idea that markets are unstable, inefficient and risky does not suggest newsworthiness on the order of Man bites dog. But, then again, most of us aren’t financial economists.

“If you do the math, [portfolio risk] naturally breaks down into two components,” Simsek says — the inherent risk of investing and speculative variance. His paper shows that “as you increase assets, this speculative part always goes up” and that “when disagreements are large enough, this second effect is dominant and you end up increasing the average [portfolio risk] as well.”

I don’t know when these higher risks will manifest themselves and send the markets reeling. It may happen this week or years from now. These cycles are not predictable. This is not a market forecast. But happen it will, probably unexpectedly and in a surprising way with surprising effects. Perhaps even worse, the huge derivatives risk-add comes from Wall Street (whose denizens so consistently think they have a working knowledge of the entire universe) yet, when such a day of reckoning ultimately arrives, history suggests that it’s Main Street that will pay the price for it.